The Top-Performing Sustainable Funds

If you were looking for a reason to invest in companies that promote good values, consider the recent trials of
Equifax.
Around the time that hackers were gaining access to the personal information of 44% of the U.S. population in Equifax’s databases, researchers for a service popular with many socially responsible investors were warning them to avoid the shares. Equifax had weak data and privacy security, it charged, and exhibited poor citizenship by engaging in misleading marketing, for which it had been fined by the U.S. Consumer Financial Protection Bureau. Its governance, although improving, was also weak. Its CEO, for example, was paid five times the median for executive officers around the country and also held the chairman’s role. Not least, the company’s independent lead director had been around for 25 years.

That analysis, by MSCI’s sustainable-investment research arm, steered investors clear of Equifax (ticker: EFX). Similar analysis helped institutional investors avoid
Valeant Pharmaceuticals International
(VRX), whose shares plunged after it came under investigation for price-gouging, among other improprieties, and Volkswagen (VOW3.Germany), which was found to be cheating on emissions tests. Sustainable investing, which focuses on environmental, social, and governance factors, or ESG, not only focuses investors on sound corporate behavior, but often keeps capital safe.

“There’s a long-run advantage in ethical businesses,” says Robert Shiller, the Nobel laureate and Yale University economist. “They have a good chance of outperforming” the stock market. Likewise, ESG-focused funds often outperform their non-ESG peers.

Barron’s second annual survey of sustainable funds in Morningstar’s database found a similar trend toward outperformance, confirming last year’s study. Morningstar partner Sustainalytics evaluates the sustainability of 8,000 companies worldwide using more than 100 ESG factors, such as incidences of environmental accidents, fraud, and discriminatory behavior. Morningstar also uses Sustainalytics’ data to score 35,500 funds in its database based on their holdings. Barron’s used the Morningstar data to screen for large-company U.S. stock funds with sustainability grades of “above average” or “high.” A Standard & Poor’s 500 index fund has an “average” sustainability rating.

We focused on funds with assets exceeding $300 million, and came up with a list of 203, with more than $1 trillion in total assets. We then ranked these funds by one-year returns for the 12 months ended on Sept. 30.

Two years doesn’t make a trend. But we found that 76 funds, or 37% of those on our list, beat the S&P 500 for the 12 months, compared with 28% of actively managed U.S. large-cap stock funds in the same period. Last year, a quarter of the funds on our list beat the market, compared with 12% for the larger group, according to Morningstar.

SUSTAINABLE INVESTING is gaining traction in Corporate America. When Parnassus Investments, a team of socially responsible investors, visited the offices of Walt
Disney
(DIS) in March, they were shown into a boardroom decorated with sketches and models of iconic Disney characters. Disney is one of largest holdings of Parnassus, which has $25 billion in assets, and is dwarfed by Vanguard and BlackRock, index-fund leaders that together own more than 10% of Disney. Within a few minutes, a tanned, relaxed-looking Bob Iger, Disney’s CEO, strode in. It was the first time he had sought out the managers.

“Part of our brand is we want to be known as warm and fuzzy—it’s very important to us to be perceived as good,” Iger told the investors by way of explanation. He then grilled the investors about what they thought of several Disney initiatives. He also asked Parnassus’ opinion of how companies report ESG metrics. “More companies are pinging us about best practices,” says Ben Allen, Parnassus’ president.

In a recent letter to investors about growth,
Bank of America
CEO Brian Moynihan wrote, “Our environmental, social, and governance (ESG) practices are central to growing in a sustainable manner.” A special ESG supplement was enclosed in BofA’s annual report. And even as President Donald Trump took steps to pull out of the Paris climate agreement, 50 U.S. companies, including
Gap
(GPS) and
Nike
(NKE), signed on to set science-based climate targets and reduce carbon emissions. Early this year, BlackRock and
State Street
announced that climate change was their top priority in direct engagements with companies.

“ESG HAS BECOME ACCEPTED as a mainstream approach to investing,” says Amy O’Brien, managing director and head of responsible investment at Nuveen. The firm runs $929 billion, of which a large chunk is in sustainable investments, including the nation’s oldest ESG fund.

The challenging part of ESG analysis isn’t a lack of data, it’s too much data, says Bruno Bertocci, head of UBS’ sustainable equities. “Companies report all kinds of stuff as part of a global reporting initiative, so you end up with a giant pot of soup with stuff floating in it,” he says. “It’s reminiscent of those early days in collecting global financial data.”

More than 100 organizations, including Bloomberg and Thomson Reuters, provide ESG ratings. Major investment firms, including
Morgan Stanley
and
Goldman Sachs,
have been buying up ESG firms. Last year, money manager
Eaton Vance
purchased Calvert, an ESG fund shop, and S&P Dow Jones Indices bought carbon and environmental data analysis firm Trucost. This year, Morningstar purchased 40% of Sustainalytics, and Impax Asset Management bought Pax World Management. One respectable newcomer is Arabesque Asset Management, whose S-Ray product streamlines data from a number of sources to make it easier for managers to assess.

Moreover, a bewildering array of institutions is setting standards. UN PRI, which originated at the United Nations and is endorsed by a host of European institutions—which have been swifter to adopt sustainability as an investment criterion—includes voluntary principles for responsible investment. The Sustainability Accounting Standards Board offers guidance on metrics and disclosure for topics including greenhouse gas emissions and labor practices. The Forum for Sustainable and Responsible Investment also advises on best practices. The UN Sustainable Development Goals identified 17 goals—such as eradicating poverty, ending famine, and building resilient infrastructure—to achieve by 2030. Some 100 countries have signed on, and many public companies, such as
Unilever
(UL),
Hewlett Packard Enterprise (HPE),Novartis
(NVS), and now Volkswagen, all reference sustainable development goals in their annual reports and are using them as a benchmark.

Investors use the sustainability data differently because sustainable means a lot of different things. For some, it means what it used to mean—socially responsible investing, a simple strategy that merely excludes companies that negatively affect society, like tobacco companies or weapons makers. ESG funds go a step further, and actively look for companies with the best environmental, social, and governance practices across their industries. Some invest according to religious or political principles. Some are sector funds.
Fidelity Select Environment and Alternative Energy Portfolio
(FSLEX), for example, invests in alternative energy and sustainable agriculture.

Within the fund industry, too, some managers barely use ESG, while others use it heavily. And some are deploying the criteria in a more activist manner. At Fidelity, for example, a new ESG office is sifting through corporate proxies and alerting portfolio managers. Says Scott O’Reilly, a Fidelity vice president who helps look after the firm’s sustainable investing efforts: “ESG is more about risks than alpha opportunistic.”

OUR LIST is a good place to start researching your sustainable investments, but we offer it with the usual caveats. It includes funds that score highly on Morningstar’s sustainability ranking—but that doesn’t mean they identify themselves as sustainable investors: indeed, most don’t. (Last year’s No. 1 and No. 2 funds fell off the list because they scored an “average” or “below average” sustainability rating this year.) In fact, you won’t run into the first fund that explicitly identifies as sustainable until No. 23—
Parnassus Endeavor
(PARWX).

At Hotchkis & Wiley, whose funds rank highly this year, ESG is just one of the myriad variables considered along with other assessments, such as the long-term viability of cash flow—which benefits from good governance and sustainable business models—says Scott McBride, co-manager of
Hotchkis & Wiley Large Cap Value
(HWLAX). The fund’s performance this year was driven partly by Bank of America (BAC) and
Microsoft
(MSFT), which rate highly on Sustainalytics’ ESG criteria.

Tops on this year’s list is
CGM Focus
(CGMFX), a notoriously volatile fund whose longtime manager, Ken Heebner, takes large positions and trades heavily without regard to ESG criteria. A CGM spokeswoman declined to talk to Barron’s. (For more on this fund, see “Beyond Sustainability Scores”.)

Second is
Vanguard Capital Opportunity
(VHCOX), run by Primecap Management, a team of well-regarded growth-stock pickers. The fund’s largest 10 holdings—among them
Biogen
(BIIB),
Eli Lilly
(LLY),
Southwest Airlines
(LUV), and
Alphabet
(GOOGL)—account for a third of assets. Says Dan Newhall, the Vanguard official who manages the relationship with Primecap: “It’s not a goal of the managers to achieve high sustainability ratings; it’s a function of the stocks they’re selecting.”

Third is
MassMutual Select Equity Opportunities
(MFVSX), a fund that’s only available in retirement plans. Until March, the fund was run by Harris Associates, which also runs the Oakmark Funds. (An Oakmark fund shows up later in the list; the firm declined to comment.) Today, the fund is run by Wellington Management and
T. Rowe Price,
both of which use ESG criteria to evaluate stocks. Wellington’s Don Kilbride owns 20 to 40 companies that are increasing their dividends and have good industry positioning and sustainable franchises. T. Rowe’s John Linehan also invests in 30 to 40 stocks. “Our goal is to deliver high excess return with two different concentrated managers,” says Doug Steele of MassMutual. “Having a consistent profile can keep people invested over the long term.”

Fourth is
Putnam Multi-Cap Core
(PMYYX), a go-anywhere fund. Manager Jerry Sullivan’s methods—investing in deep value and “special situations”—make for volatile performance. In 2013, it returned 42%, beating 99% of large-blend peer funds and the S&P, but fell nearly 3% in 2015. Huge inflows probably affected performance; assets jumped from $10 million to more than $400 million from 2012 to 2015, and the portfolio bloated from 200 stocks to 370, according to Morningstar. Sullivan is working on keeping the fund in the 80-to-100 stock range.

Fifth and sixth are two funds run by
Pioneer,
a unit of Amundi, a French investment manager with a long history of socially responsible investing. Craig Sterling, co-manager of
Pioneer Core Equity
(PIOTX) and
Pioneer Disciplined Value
(CVFCX), credits large-cap biotechs that exploded into favor, and managed-care stocks that performed well right after the election and even more so as the effort to repeal the Affordable Care Act has failed. High-quality financials and chip makers also helped performance.

Sterling relates that his team “focuses maniacally” on durable investment models. “To do this would be impossible without an assessment of the risks of a company’s environmental and social business practices,” he says, including emissions, raw-material sourcing, and how it treats employees. Governance is critical, too. Today, he likes large tech firms and is avoiding consumer staples that are facing accelerating challenges to their business.

AFTER THE U.S. ELECTION, interest in ESG data certainly picked up among asset managers and advisory firms, according to providers. Individuals have been particularly concerned about the incoming administration’s hostility to the Environmental Protection Agency, says Lisa Woll, CEO of the Forum for Sustainable and Responsible Investment. “When you have a government closed for business around environmental concerns, you’ve got to turn to the states and private sector,” she says.

The Department of Labor rescinded language relating to fiduciary duty and ESG analysis in 2015, and late last year admitted that its previous guidance “may have discouraged Erisa plan fiduciaries from exercising their shareholder rights.” Having an impact on society at large might become a central part of pension plans and endowments.

Today, we’re at what Art Steinmetz, CEO of OppenheimerFunds, dubs “version 1.0” of ESG. Version 2.0, he says, is where ESG isn’t a separate category of investments but just a natural part of active management. That’s a view that’s echoed by UBS Asset Management’s Bertocci. To him, ESG criteria is “Graham and Dodd 2.0—an extension of the analytical process.”

Inevitably, too, it will shape how corporations conduct themselves—and change the face of the investment industry. “Investor capital is the biggest driver of corporate behavior,” says Jeff Gitterman, founder of Gitterman Wealth Management, which runs $100 million in sustainable portfolios out of $1.5 billion under management. “If demand is there, if the products are there, and we get the advisors on board, then the pale stale male advisor community is behind us.”

Who Didn’t Make Our Sustainable Funds List

Of the 55 actively managed U.S. equity large-company funds with sustainable goals of every stripe—religious, environmental, or other—37 did not make our list. Most didn’t meet our $300 million assets threshold. (To see the performance ranking of all 37 click here.)

“ESG funds have a chicken/egg problem,” Morningstar’s head of sustainability research, Jon Hale, told Barron’s. Many funds are too new; of the 37 not on the list, 13 of them were launched less than three years ago.

But 14 funds weren’t sustainable enough, earning an “average” or lower sustainability rating, according to Morningstar. Many fell off our list for the second consecutive year. They include
Ariel Focus
(ticker: ARFFX),
Invesco Summit
(SMMIX),
GuideStone Funds Value Equity
(GVEYX),
LKCM Aquinas Catholic Equity
(AQEIX), and
American Century NT Equity Growth
(ACLEX). Two “no tobacco” versions of American Century funds that made our list last year were not ranked sustainable enough this year. Morningstar says the funds are ESG-focused, but they aren’t actually doing any ESG analysis. They’re merely “NT,” or no-tobacco, versions of the originals.

Newer funds that focus on ESG analysis rather than screening are starting to put up promising performance. The top 10 best performers that didn’t make our list all beat the Standard & Poor’s 500 index, and half of them are newcomers that get “high” marks on sustainability, have less than $60 million in assets, and are under three years old. If the $17 million TCW New America Premier
Equities
(TGUSX) were bigger, it would’ve been No. 2 on our list, knocking out the $15 billion
Vanguard Capital Opportunity
fund (VHCOX). Joseph Shaposhnik manages the TCW fund, which has a quality bent; Shaposhnik prefers businesses that have solid free cash flow, high barriers to entry, and, of course, good ESG scores. The fund returned 28.4% in the past year through Sept. 30, compared with Vanguard’s 25.8%, after fees.

The $319 million
Dreyfus Sustainable U.S. Equity
fund (DRTHX), formerly Dreyfus Third Century, is, as of May, subadvised by Newton Investment Management, a London-based firm with a track record of sustainable investing dating back to 1978. The name change is not a formality. The fund now owns just 35 to 40 stocks, from about 75 previously, and its core focus is on active engagement. “We don’t blanket-exclude sectors,” says John Gilmore, a fund manager at Newton. “We look at what’s material, and gauge whether we can change a company through engagement.” They don’t hold any tobacco companies, because the issue is about the products and company behavior, says Gilmore. He doesn’t think he could make a tobacco company change its ways, regardless.

The fund has an average sustainability rating from Morningstar, but Gilmore pointed out that the fund ranks in the top 7% of all other U.S. equity funds, according to MSCI’s ESG fund database. He doesn’t take issue with Morningstar’s rating. “We would not say MSCI data is better than Sustainalytics,” he says. “The variability is part of developing a picture of what is in your fund.”

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